Reforming Corporate

Governance: The Key to Improving Executive Pay

Jesse FriedHarvard Law School

Washington D.C.May 4, 2010

My work with Lucian Bebchuk offers a critical account of the CEO pay- setting process and its outcomes. Today’s remarks:

(1) the basic problem with the CEO pay-setting process(2) why giving shareholders more power should reduce this problem.

Executive Pay: The Stakes

Excess pay costs shareholders Poorly structured pay arrangements:

Dilute incentives to serve shareholders Distort incentives –

E.g.: ability to unwind stock early causes execs to focus on short-term earnings, at expense of long-term value

“Official View” of Executive Compensation

Arm’s-length bargaining with execs Executives are human – seek higher pay, regardless of

performance But directors, loyal to shareholders, bargain hard with execs

design pay to properly compensate, incentivize execs CEO pay is a market like any other

The official view underlies most financial economists’ work on subject used to justify boards’ compensation decisions to

shareholders policymakers courts

Problem with Official View

The official arm’s length story is neat, tractable, and reassuring – but fails to account for realities of pay-

setting process

It’s not only executives whose incentives matter. Must look at incentives of directors Cannot assume directors automatically

serve shareholders in setting executive pay.

Do Boards Bargain at Arm’s Length?

Many reasons directors favor executives: Incentives

Going along w/CEO facilitates re-nomination by board 99+% board elections not contested

CEO’s power to reward directors Social factors

Collegiality Loyalty and friendship Cognitive dissonance

directors who are/were CEOs like current system Personal costs of favoring executives are small

Paying with other people’s money

Warren Buffett (2009)

“In the [last] forty years, …the CEO has had an important role determining their [own] compensation. These people pick their own compensation committees…. [they] aren't looking for Dobermans; they're looking for cocker spaniels. It's been a system that the CEO has dominated. In my experience, boards have done little in the way of thinking through as an owner what they ought to pay these people.”

The Managerial Power Approach: Power, Outrage & Camouflage

The same factors preventing arm’s-length bargaining give executives power over boards

Executives use power to influence own pay Pay higher, more performance-decoupled than it should be

Power not unlimited, of course; constrained by fear of

shareholder outrage More outrageous an arrangement is perceived to be, greater market

and social costs to executives and directors

Fear of outrage creates desire to camouflage (obscure or justify) both amount, performance-insensitivity of exec pay

Evidence for Managerial Power Approach

Relationship between power and pay

More power, higher pay More power, pay more decoupled from performance

Gratuitous payments made to outgoing executives

Equity and non-equity pay that is decoupled from executive’s own performance

Camouflage-driven pay practices

Camouflage pre-1992: An SEC official describes pre-1992 state of affairs as

follows:

“The information [in the executive compensation section] was wholly unintelligible . . . .

Depending on the company’s attitude toward disclosure, you might get reference to a $3,500,081 pay package spelled out rather than in numbers. ……….

Someone once gave a series of institutional investor analysts a proxy statement and asked them to compute the compensation received by the executives covered in the proxy statement. No two analysts came up with the same number. The numbers that were calculated varied widely.”

Linda C. Quinn, Executive Compensation under the New SEC Disclosure Requirements, 63 U. Cin. L. Rev. 769, 770-71 (1995).

Camouflage post-1992 (1) 1992: Summary Comp Table

Firms required to report most forms of compensation in standardized tables with dollar amounts

Salary Bonus Long-term incentive compensation

But post-1992 pay designers began relying heavily on forms of compensation not reportable in table (eg SERPS) performance-insensitive compensation that can be reported

as something other than “salary” Made to look performance-related. E.g.: “guaranteed bonus”

2007: SEC “fixes” table to capture SERPs, etc.

Camouflage post-1992 (2) Backdating, Etc.

option grant backdating to lower exercise price Inflated value of stock options “under the radar screen” $ billions, thousands of firms

United Health: $500M paid back by CEO (2007) option exercise backdating, grant springloading

All of this secret compensation hard to reconcile with official arm’s-length story but consistent with managerial power approach

Going Forward: What Should be Done?

Root problem: directors don’t care enough about shareholders “Independence requirements” don’t make

directors loyal to shareholders We should make it easier to replace directors

Majority-voting Give shareholders access to corporate ballot Reimburse proxy challengers attracting

considerable support Directors would be more likely to consider

shareholders’ interests if greater fear of removal

Making Directors More Accountable

By making boards accountable to shareholders and attentive to their interests, such reforms would:

make reality closer to the “official story” of arm’s length negotiations

improve executive compensation arrangements; &

improve corporate governance more generally

End

Introduction

Widespread agreement: many U.S. boards have approved executive pay deals that do not serve shareholders Pay too high Pay too decoupled from performance

But still insufficient recognition about scope and source of problems; and need for fundamental reforms